Wednesday, January 27, 2010

Financial Crises and Economic Activity

Our objective here is not to explain the causes of the current crisis. Instead we study the consequences. To do that, we examine the evolution of the real costs of financial crises to get some sense of when things are likely to improve. (H/T Shai)

This paper studies the length, depth and output costs of a sample of 40 systemic banking crises in 35 countries since 1980 to assess the likely real impact of the current crisis.

Most, but not all, systemic banking crises in our sample coincide with a sharp contraction in output from which it takes several years to recover.
The current financial crisis is unlike any others in terms of initial conditions, industrial and institutional structures, levels of development, degrees of openness, policy frameworks and external conditions. Simply averaging outcomes of past crises to get a reading on the current one is therefore likely to be misleading regardless of the sample or subsample. With this in mind we go on to study the determinants of the output losses from past crises.

Our findings suggest that the costs are higher when the banking crisis is accompanied by a currency crisis or when growth is low immediately before the onset of the crisis. Furthermore, when it is accompanied by a sovereign debt default, a systemic banking crisis is less costly.

The final part of the paper takes a longer-term view and study the impact of crises on potential output several years down the road. We find that many systemic banking crises have had lasting negative effects on the level of GDP. And even in those cases in which trend growth was higher after the crisis than it had been before, making up for the output loss resulting from the crisis itself took years.

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